A Value Added Tax (VAT) is a tax on the amount by which the value of an article has been increased at each stage of its production or distribution. Tax is levied on the value added to goods by each business unit in the production and distribution chain. Basically, it is measured by the difference between sales and purchases. Each firm in the chain collects tax on the amount of sales and takes credit for taxes paid on purchases. The difference is remitted to the taxing authority.
Some taxes are based on the “ability to bear” principle, which holds that taxes should be based on the ability to pay. This would include income taxes and taxes based on wealth (like inheritance taxes). These taxes tend to be progressive, in that the more you make or have, the more you pay.
Other taxes are based on the “benefits received” principle which holds that taxes should be levied on the benefits received for goods and services, or consumption. Some examples would be a fee for using a public park or a fee for a toll road.
VAT would be considered a consumption tax. The consumer ultimately bears the burden of this tax through higher prices. Consequently this tax encourages saving because it is based on consumption, not saving (of income or wealth). Thus lower income consumers will tend to spend a higher percentage of their income on taxes than higher income consumers. Thus the VAT is considered a regressive tax.
My interest in VAT is based on the conclusions of a book, On The Brink, written by Henry Paulson, Jr., President George W. Bush’s Treasury Secretary. He presided over the US Treasury during the onset of the most wrenching financial crisis since the Great Depression. A time known to those of us that lived through it (anyone reading this) as the Great Recession, Paulson’s book covers the time period between late 2007 and when he left office in January 2009, when Barack Obama’s administration took over. During the worst of this time (March to September, 2008), eight major financial institutions failed. These failures were such that intervention was needed to curb electronic “runs” similar to what in the 1930’s would have equated to everyone running to the bank and wanting to withdraw their money on short notice. A scene from the movie It’s A Wonderful Life comes to mind. These financial institutions started with Bear Sterns and eventually included Lehman Brothers, IndyMac, Fannie Mae, Freddie Mac, AIG, Washington Mutual and Wachovia. Government intervention of hundreds of billions of dollars (YES Billions) was needed to prevent calamity.
Paulson concludes his book by discussing lessons learned and suggesting ways to avoid similar calamities in the future. In the US we save way less than we consume. This ultimately forces us to borrow from countries that save more than they consume. The crisis has abated but these imbalances persist. His recommendations include the practice of fair value accounting, a regulatory system that can keep pace with financial innovation, and moving toward a tax code that is based on consumption rather than income.
Most industrialized countries in the world have a tax that resembles VAT (various exemptions and reductions are allowed for certain necessities to alleviate the regressive nature of this tax). In Canada it’s the GST/HST tax. Countries of the European Union are required to levy VAT as a condition of their admittance into the EU. State sales tax is a consumption tax but is only levied on the end user.
With VAT, all businesses pay tax, with income tax only profitable businesses pay tax. Which is the better way? What are your thoughts?